How to Use Fixed Income in Different Economic Scenarios
Markets move in response to many factors, including political and global events, company news, central bank interest rate decisions, and emerging themes that affect specific industry sectors.
These shifts affect all asset classes, but equities and fixed income behave differently:
- Equities: Share prices can decline even when companies report strong results. This can happen if investors believe the stock is overvalued, want to lock in profits, or expect even better performance. Market sentiment and valuation considerations often drive share prices, sometimes more than company fundamentals.
- Fixed income: High-quality bonds, especially government bonds, tend to be less sensitive to short-term news and more influenced by big-picture factors like interest rates, inflation, and overall economic health. Because bonds provide predictable income, they often look more attractive when markets are volatile.
This article explains how fixed income can be positioned in key economic environments.
Inflation and interest rates
In an inflationary environment, central banks often increase interest rates to rein in spending. Higher rates can pressure bond prices, but investors have options:
- Shorter-dated bonds: These bonds mature sooner and are less sensitive to rising rates, helping reduce interest rate risk.
- Inflation-linked bonds: Their principal and coupon payments adjust in line with changes in inflation, which may help offset the impact of rising prices on purchasing power.
- High quality investment grade corporate bonds: These bonds offer higher yields than government bonds while still carrying relatively low risk.
In a deflationary environment, or when economic growth slows sharply, central banks often cut interest rates to encourage spending. In such conditions, investors might consider:
- Longer-dated bonds: These are more sensitive to interest rate changes and have the potential for greater price appreciation as interest rates fall.
- Highly rated government bonds: These bonds provide the potential for stability and predictable income during periods of uncertainty.
- Investment grade corporate bonds: These bonds are less susceptible to the risk of default than high yield corporate bonds. Companies with strong balance sheets and solid cash flows are generally better positioned to weather potential economic slowdowns.
Increasing exposure to bonds with strong credit profiles can help lock in income and position portfolios to benefit from falling rates and rising bond prices. It’s also worth noting that when interest rates are at low levels, bonds have historically delivered better returns than holding cash.
Credit spreads
Credit spreads show the extra yield investors earn for taking credit risk. When spreads widen, it often reflects rising uncertainty or concerns about weaker corporate fundamentals. In these periods, investors may shift their portfolios toward higher‑quality bonds, such as investment‑grade corporates, to reduce risk and preserve capital.
When spreads narrow, it usually signals improving confidence in the economy or issuers’ ability to repay their debts. Investors may then feel more comfortable taking on selective credit risk, adding higher‑yielding bonds with solid fundamentals to seek additional income.
Overall, investors can adjust their credit exposure based on the market environment, leaning into quality when markets are volatile, and selectively adding yield when conditions stabilise.
Liquidity and market sentiment
When markets come under stress, some investments can become harder to trade. The prices of riskier bonds may fall, causing their yields to rise as investors demand greater compensation for the heightened risk of default. However, high-quality government or corporate bonds are usually easier to trade and their prices are generally less volatile.
When market conditions improve and investors adopt a more ‘risk-on’ stance, they may adjust their portfolios to reflect a more optimistic outlook by holding lower-quality, higher-yielding bonds or bonds issued by governments or companies in emerging markets.
Evolving world events
Global events such as geopolitical conflicts, trade disputes, or public health crises can all impact financial markets. When prices decline due to these unpredictable shocks, investors are described as being in a ‘risk-off’ mood. In this environment, they typically reduce exposure to higher‑risk assets and shift toward investments perceived as safer. High‑quality fixed income is often viewed as a relative “safe haven” during such periods, and demand for these assets tends to increase.
Once market turbulence subsides, investors often rotate out of “safe haven” assets and into higher-yielding assets offering higher return potential, like equities or lower-quality bonds.
Putting fixed income strategies into practice
Different types of bonds respond differently to economic and market conditions, which is why fixed income can play an essential role in helping investors manage risk and maintain diversification within a balanced portfolio.
Successfully positioning fixed income portfolios across changing economic scenarios requires flexibility and a clear understanding of market dynamics. This can involve adjusting factors such as maturity, credit exposure, and sector allocation to reflect evolving conditions. These decisions can be complex, which is why many investors choose to work with professional investment managers who have the resources and expertise to monitor markets and implement strategies effectively.
